News Analysis date published New: 
Tuesday, April 26, 2011 - 09:00
New Date created: 
Thursday, August 15, 2013 - 11:09
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Tuesday, April 26, 2011 - 09:00

How Apple's Big Secret Could Spoil Netflix's Amazing Run

Tuesday, April 26, 2011 9:00 AM

Shares of Netflix (Nasdaq: NFLX) remain within a few percentage points of their all-time high. The video-rental firm has had quite a run, with its shares up more than 150% in the past 12 months and nearly 1,000% in the past three years. Even lackluster forward guidance issued on the evening of Monday, April 25, only put a modest dent in this highflying stock. But behind the scenes, a major problem looms. And that problem’s name is Apple (Nasdaq: AAPL).

Any day now, Apple is expected to announce the formal opening of a massive new data center in Maiden, N.C. This center has been ready to go for several months, with its opening possibly delayed by plans to start building an identical data center right next door. Why should investors care? Once these buildings are open for business, the entire Apple business model will see a complete overhaul. And Netflix may be in the company’s sights. For that matter, a raft of other technology firms could see a completely altered competitive landscape as well.

Before looking into Netflix, a few words about Apple. I had been fairly bearish on Apple's stock for the past six months. As its share price continually hit new highs, I wondered if investors were forgetting that this was still largely a hardware-based business model. And from the Sony (NYSE: SNE) Walkman to the Motorola (NYSE: MMI) RAZR, hot products don't usually maintain their leadership over several decades. Yet Apple's looming data center plans have me seeing the company in a new light.

What might Apple do with this data center? Speculation abounds that Apple will offer huge amounts of cloud storage for its customers -- a wise move, considering the high cost of flash memory built into every iPad. With access to online storage, device-based storage becomes a lot less important. Yet Apple likely sees an opportunity to open whole new lines of business. For example, a streaming music subscription service (similar to one that Google (Nasdaq: GOOG) is developing) can be priced quite aggressively and still lure away many customers from companies like Sirius (Nasdaq: SIRI) and Pandora Radio, the Internet-based automatic music recommendation service. (The next generation of car and home stereos is likely to be glorified Internet receivers, obviating the need for expensive satellite networks like the one operated by Sirius.)

This company should be really worried
Yet Apple's data center strategy may really be aimed at stealing business away from Netflix. The video delivery service is on track for $3 billion in sales this year and $4 billion by 2012, according to analysts. That's just a fraction of Apple's $25-30 billion in revenue, yet Apple is surely aware investors have shown ample affection for Netflix's service-based business model. Netflix is valued at more than six times trailing sales while shares of Apple trade for less than four.

Why would Apple want this market? Because Apple needs to keep figuring out ways to squeeze more revenue out of its projected 50 million iPad users. The device is basically a high-definition TV screen that can also play iTunes and surf the Web. (Rumors also abound that Apple may be looking to roll out its own television set.) In contrast, Netflix has no natural home and must instead keep scrambling to make sure it is easily accessible on other hardware devices such as advanced TV sets and video game players.

Could Apple easily mimic Netflix's business model? Not right away. Netflix has done a remarkable job of securing content deals with major film studios and TV networks. Yet those deals must be renewed every few years, and those content partners are becoming increasingly frustrated with the control Netflix now exerts over the TV and film industry.

Of course, Apple is not exactly seen as a friendly potential partner to the studios. After all, a number of music labels have fallen into the abyss after Apple's iTunes music store appeared on the scene. Apple will need to be very careful to structure deals with the TV and film business so that they are seen as an opportunity to expand the pie.

The threat from Apple -- real or imagined -- should cause Netflix shareholders to more closely examine the risk/reward profile of the stock. Netflix has become a clear hit among consumers simply because it is very convenient and its service is reasonably-priced. But these aren't "sticky" customers. Many would easily switch to a different service that is either easier to use or more attractively priced. That's likely the thought behind Apple's data center plans. Once the first 500,000 square foot facility comes online, Apple will be generating high fixed expenses and low variable expenses. (Apple's current data center in Newark, Calif., is just 100,000 square feet.) This means streaming audio and video services can be priced aggressively while still yielding incremental margin gains.

One look at the relative valuations of these two companies also gives the impression that the risk/reward for Netflix shareholders now looks less appealing. Shares of Netflix trade for more than 35 times projected 2012 profits while Apple's 2012 multiple is around 12. (The fact that Apple tops profits estimates by about 20% every quarter likely means that 2012 profit forecasts are too conservative as well.)

Action to Take --> More than likely, there's room for both of these companies in the video-streaming business. Yet Netflix isn't really well-positioned to give up a big slice of market share. It has paid dearly for the rights to major movies and TV shows (a recently announced deal to stream the critically acclaimed hit television series "Mad Men," for example, likely cost $75-100 million). To cover rising licensing costs, Netflix is counting on an ever-increasing number of subscribers. If and when Apple starts to poach some of that base, Netflix's margins could quickly take a hit. Adding more concern, other firms such as Amazon.com (Nasdaq: AMZN) and DISH Networks (Nasdaq: DISH) are said to be ogling the video streaming space, according to the L.A. Times.

Back to Apple, it's not just Netflix and Sirius that should be worried. An increasing number of consumers are tiring of expensive cable bills that deliver many channels they'll never watch. A la carte access to specific channels could be part of Apple's master plan as well. With 500,000 square feet of data center space about to come on line, Apple will have ample capacity to deliver such specialized video delivery services. When a second identical facility opens for business down the road, Apple can move even deeper into this niche. By then, cable firms such as Time Warner Cable (NYSE: TWC) may also have plenty to fear.

P.S. -- Few investors realize that a 20-year energy agreement between the United States and Russia is about to expire. This deal supplies 10% of America's electricity. As broke as our government is, the situation is so serious that President Obama is asking for $36 billion to avert this crisis. And Republicans support him. Here's what's going on…

David Sterman does not personally hold positions in any securities mentioned in this article.
StreetAuthority LLC does not hold positions in any securities mentioned in this article.